A Guide To Understanding Cash Flow

Written by
Marissa Saini
Last Modified on
December 19, 2023

understanding cash flow

As part of a company's monthly accounting cycle, every business must prepare two financial statements, which are the income statement and the cash flow statement. The income statement shows the company's profit or net income while the cash flow report shows the position of the company's cash. The latter is often less emphasised, but experienced business owners will tell you that it's often the more important of the two. We find out why.

What is Cash Flow?

We will now discuss about cash flow. The company's cash flow at a point in time is the difference between cash available at the beginning of the period and at the end of the period. Loan proceeds, income, and asset sales are all included in the cash, and it goes out to pay operating expenses, principal debt services, and purchase of asset such as equipment. Cash is king for small businesses.

Cash flow can also determine whether your business will skyrocket, or plummet in the future. Here are the various aspects of cash flow statements so you can analyze your own company's cash flow.

How to Do a Cash Flow Analysis

Analyzing cash flow is a method to check the health of your business finances. Correct cash flow analysis ensures that your cash can last and is sufficient for your monthly operations.

  • The first thing you have to do is to make a cash budget, which is a short-term financial forecast plan. Determine the amount of cash that flows in and out of the company for a month. For a new business, consider the initial cash balance that you want to have.
  • After that, you need to calculate how much to pay for your regular expenses such as purchase of office items or other monthly expenses. Usually, you are also subjected to quarterly expenses such as taxes. All regular expenses should be scheduled.
  • Third, make sure that the cash inflows per month are greater than the cash outflows so that you have enough money for the company's operating expenses. It is better to have someone experienced to calculate your company's cash flow.

The final balance for the first month will be the starting balance of the second month. You do the same analysis every month. As your business grows, you may have to add more items in the cash flow analysis. You need to decide on a minimum ending cash balance for each month so the company's operation can remain stable.

If your cash flow turns negative for any month, you have to look for investors or loans for that month. If the cash flow is back to positive the next month, you can pay back the loan.

The Difference between Cash Budget and Cash Flow Statement

Creating a cash flow statement is important for the survival of your small business. However, there are many people who are still confused between cash budget and cash flow statement. What is the difference?

Cash budget helps businesses to manage the company's capital which is usually budgeted for each month or quarter. You can think of cash budget as a short-term financial instrument; it's easier and faster to prepare compared to cash flow statement.

The cash budget document tells a company how much money is available at the end of each month. If the cash budget shows an increase in net working capital then that increase can be used to reduce operating costs or pay loans.

A cash flow statement is a more comprehensive report, prepared together with the balance sheet and income statement. Hence, the cash flow statement is a more formal presentation of the credit and debit items in the cash budget.

Comparative Balance Sheets Analysis for Cash Flow Statement

As discussed earlier, cash flow statement requires information from the past two years’ balance sheets and compare the difference between the two. In other words, a comparative balance sheet analysis is done to develop a cash flow statement. First, consider the increase or decrease in assets and current liabilities account in the two-year balance sheets. Not only that, cash flow from operating activities must also be considered because it can either be negative or positive.

Cash flows from investing activities include any long-term investments plus investment in fixed assets. This is a cash flow that must be considered once every year.

Cash flows from financing activities are cash flows from financing sources like long-term bank loans. Payment of loans from banks and investors are also included in this part of cash flow.

After calculating each part of the cash flows, you can combine the three into a net cash flow for the whole company.

How to Prepare a Cash Flow Statement with Indirect Method

There are 2 methods to prepare a cash flow statement. The first one is the direct method and the second one is the indirect method which is generally preferred by most companies for its simplicity. The difference between the two methods lies in the operating activities section. If the method directly implies cash receipts from operations as well as cash disbursements, the indirect method starts with the net income from the income statement which is then adjusted for non-cash items like depreciation.

The data you need to prepare a cash flow statement come from comparative balance sheets. There are some income statement data and two-year balance sheet data which are required to eventually develop a cash flow statement. First, you need to prepare cash flow data from operating activities and calculate the net income. Consider an increase or decrease in assets and current liabilities account between the two years of balance sheet information. Next, the net cash flow from operating activities will be included as the first section of the cash flow statement.

Cash flows from investing activities cover any long-term investments by the company plus investment in fixed assets. Prepare the net cash flow from investing activities to be the second section of the cash flow statement.

Cash flows from financing activities must also be prepared in details where cash can come in or flow out from lenders such as banks or investors. Calculate the net cash flow from financing activities as the third section.

Net cash flow comes from three sections of the cash flow statement to see where the firm is from the cash flow perspective. For instance, there can be a net increase in cash flows over the year for the company.

Free Cash Flow Calculation

The last point is one of the most important things when analyzing cash flow as a small business owner. Free cash flow is the cash that a company has left after paying out all capital expenditures (such as factories or other equipments).

Free cash flow is usually included in a cash flow analysis and it becomes quite important considering that many company frauds have arisen. The reason why investors now look into the concept of free cash flow is it is not easy to manipulate compared to earnings per share or net income.

Free Cash Flow Sources

Ways to calculate free cash flow:

  • Sales Revenues - Operating Costs and Taxes - Required Investments in Operating Capital
  • Net Operating Profit After Tax - Net Investment in Operating Capital
  • Net Cash Flow from Operations - Capital Expenditures.

Calculate Your Company's Cash Flow Ratios

Some financial ratios, such as operating cash flows, price/ cash flows, and cash flow margin, help business owners to focus on cash flow.

By calculating these cash flow ratios, you will get more information about liquidity, solvency, and viability of your company.

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Frequently Asked Questions

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About the author
Marissa Saini
is a seasoned writer and an avid trendspotter across business finance, personal finance, travel and lifestyle industries. With writing history at SingSaver, INK, and ohmyhome, Marissa leverages her broad range of experiences to simplify finance and make readers financially savvy.
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